Sunday, April 6, 2014

In a recent post, Carl Swenlin calculated the trailing GAAP P/E ratios of the SP 500. He used on a simple rule of thumb that the market is undervalued at a P/E of 10 and overvalued at 20. Based on that simple metric, he declared that the market is vulnerable to a pullback because valuations are nearing the top end of the historical range of a P/E ratio of 20, which would amount to a SPX level of about 2000.

Does that mean that stock prices are about to roll over and play dead? Not necessarily. What the bull market needs to keep going is the E in the P/E ratio to expand. The US is in the mid-cycle of an expansion and what typically happens mid-cycle is an acceleration in capital expenditures. Josh Brown eloquently summarized this point of view in a TV interview here.

To put Brown's comments into my own words, the economic doctors at the Fed have decided that the patient is stable and ready for the gradual withdrawal of the heavy cocktail of stimulus drugs being pumped into his system. Soon, he will be recovered enough to start walking on his own. One of the key signs of a true recovery is sufficient business confidence to start investing more into their own operations.

That's why, this Earnings Season, I will be carefully monitoring the tone of the guidance from capital goods giants such as GE, Caterpillar and so on.

Waiting for Godot?
Unfortunately, waiting for the capex cycle to revive itself during this economic recovery has been like watching Waiting for Godot. Larry Fink recently complained about the lack of capital expenditures among American companies:

Laurence Fink, chief executive officer of Blackrock Inc., the world’s largest money manager with more than $4 trillion in assets, recently issued a warning to U.S. companies: Stop focusing on short-term returns at the expense of longer-term investments.

“It concerns us that, in the wake of the financial crisis, many companies have shied away from investing in the future growth of their companies. Too many companies have cut capital expenditure and even increased debt to boost dividends and increase share buybacks.”

Fink complained that companies were overly focused spending cash on buybacks and dividends rather than investing in their own businesses:

Companies only have a finite amount of cash to invest. Whatever gets spent on buybacks and dividends is that much less available to be spent on investments in employees, research and development, and capital expenditure. It's basic arithmetic.

When will the next round of capital investment begin in earnest? As soon as you figure out the answer to that question, you will have gained significant insight into the direction of the economy as well as the next phase of this stock-market rally.

The following chart (via Business Insider) of capex by sector provides some perspective to the puzzle and also raises some interesting questions.

So far, the heavy lifting in capital expenditures in this cycle has come from the Energy sector, which makes sense given the level of spending on the shale oil and gas plays in the US. Depletion rates in tight oil and gas formations are horrendously high so companies have to keep spending in order to maintain production levels (see this analysis from James Hamilton). By contrast, the share of capex investments by the Consumer Discretionary sector has dropped by roughly half compared to the heady days of 2006-2007, the top of the last cycle. Moreover, the capex share of other sectors, such as Financials, Consumer Staples and Industrials have declined as well.

Capex bulls roam the Street
Cardiff Garcia of FT Alphaville pointed out that the Street remains optimistic that an upturn in capital expenditures is just around the corner. RBC noted that the corporate intentions are supportive of an upturn in investment spending:

Goldman's top-down macro indicators are also suggestive of rising capex:

What's more, credit conditions are relatively easy and therefore debt financing is available if corporations are willing to invest:

Andrew Lapthorne: Capex bear
While most of the Street remains sanguine about an upturn in capex, the biggest bear has been Andrew Lapthorne of Societe Generale. His principal contention is that there has been little growth in cash flow to support a corporate investment revival. He looked at different measures of earnings and cash flow growth in 2013 and found that most measures showed low levels of growth:

Lapthorne pointed out that Y/Y net income growth was distorted by write-downs in previous periods (via Business Insider):

"Looking behind these headline numbers we see that the biggest increase in reported net income in 2013 came from Hewlett Packard," noted Lapthorne. "This improvement was courtesy of the large 2012 $19bn goodwill write-down (from the EDS and Autonomy acquisitions) dropping out of the 2013 figures. Indeed if we compare the biggest positive contributors to reported net income the list is very much different to the pro-forma net income figures. The top 10 biggest positive net income contributions are dominated by companies affected by write-downs in 2012."

He concluded that cash flows may not be supportive of a capex expansion in the near term:

Indeed, the results of a recently published Deloitte survey of CFOs confirmed Lapthorne's contention that reduced growth expectations may serve to restrain corporate investment. As the chart below shows, CFOs' earnings growth expectations have been on a gentle downward incline since Q1 2013.

The other key highlight of the Deloitte survey contradicts the results of the investment intentions survey cited by RBC above (emphasis added):

Capital-investment expectations held nearly steady from the prior quarter at a 6.5% gain, but were below year-earlier levels. Sales expectations for the next 12 months did advance to 4.6% in the first-quarter survey, from 4.1% the prior quarter.

In addition, analysis from Brian Belski of BMO (via Marketwatch) shows that the Consumer Discretionary sector showed a high level of negative guidance, which creates capex headwinds for a sector that has lagged its historical pace of corporate investment. As well, capital goods sensitive market segments such as Industrials and Technology were the next two sectors that showed the highest levels of downward guidance.

What does Mr. Market think?
While these bull and bear arguments are interesting, but what does the market think? I am watching the market expectations of two key characteristics of a mid-cycle expansion, namely the acceleration in inflationary pressures, which the Fed is carefully watching, and capex acceleration.

On the first score, Mr. Market is signaling asset inflation. The relative performance of the inflation-sensitive Energy sector is starting to turn up:

As well, the relative performance of Materials is constructive as it shows a relative breakout after period of relative consolidation:

One of the key charts that I am watching for that Mr. Market is signaling a capex upturn is the relative performance of the capital goods heavy Industrial sector (XLI). As the chart below shows, the picture is mixed. Industrial stocks had been in a relative uptrend against the market since last May. The relative uptrend was broken in early February and the sector has since been consolidating sideways, which indicates a lack of capex acceleration.

A broader, though slightly less capital goods intensive, indicator to watch is the relative performance of the Morgan Stanley Cyclical Index (CYC). The chart below of CYC shows that cyclical stocks remain in a relative uptrend against the market. Though there were some minor violations of the trendline, the new relative high exhibited by the index last week can be said to negate the trend violation.

At a crossroad
Today, US equities stand at a crossroad. On one hand, technical indicators are showing signs of froth (see The Chanos Sotheby's Indicator flashes a warning) and risk appetite is starting to roll over, as evidenced by the carnage in the high flying Biotechs and NASDAQ favorites such as Netflix, Tesla, as well as small cap Russell 2000 (also see my previous comment It IS about the risk premium!). On the other hand, top-down fundamental macro indicators are turning to a capex revival (notwithstanding Andrew Lapthorne's objections). What's more, Mr. Market's expectations are similar to those of the Street's capex bulls.

Who will win this argument?

I am not sure. That is why it is important to closely monitor the tone of the capital goods companies' upcoming earnings reports. Either capex intentions live up to expectations and the bull market continues to charge ahead to further new highs, or we see disappointment. In that case, the relative performance of XLI and CYC would roll over - which will be a signal that the bears have taken charge of the tape.

Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. (“Qwest”). The opinions and any recommendations expressed in the blog are those of the author and do not reflect the opinions and recommendations of Qwest. Qwest reviews Mr. Hui’s blog to ensure it is connected with Mr. Hui’s obligation to deal fairly, honestly and in good faith with the blog’s readers.”

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this blog constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or I may hold or control long or short positions in the securities or instruments mentioned.

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Welcome to my blog Humble Student of the Markets. These are my observations and musings about the markets (mostly equities), hedge funds and investments in general.My experience has been a quantitative equity manager in US, Canada, EAFE and Emerging Markets and commentator on hedge funds and their returns patterns.

DISCLAIMERThis is not investment advice! I know nothing about you, your risk preferences, your portfolio or your investment horizon. I have no idea whether any of my opinions expressed are suitable for you.

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this blog constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. I may hold or control long or short positions in the securities or instruments mentioned.